Will Fed Rate Cuts Have an Inflationary Impact?

When Federal Reserve policymakers announced the half-a-point cut in interest rates last Tuesday, I was almost at a loss for words.

As all of you know, I had projected reduction of 25 basis points, and by the time Tuesday’s meeting of the central bank’s Federal Open Market Committee (FOMC) rolled around, the market supported my view. Going into that FOMC meeting, the outlook was decidedly negative: The U.S. economy was slowing, and the lousy housing market was leading the downturn, and the global fixed-income markets are undergoing a painful restructuring. So far, everything was playing out according to our expectations.

But then the Fed surprised us with a mammoth injection of “monetary steroids.”

The central bank, seeking the Fed Holy Grail – a ‘soft landing’ – for the economy 9except for the housing sector), watched in recent months as the subprime-mortgage-induced housing problems spilled over into the fixed-income markets. Suddenly, what had started out as a domestic housing slump had turned into a global credit contagion.

While the ‘science’ of central banking includes many degrees of ‘art,’ the Fed found /itself in the difficult position of having to choose between two strategies, neither of the optimal. It could:

It could cut interest rates – on the basis of one bad employment report and the possible widening of a global credit crunch – in anticipation of a possible economic slowdown.

It could ‘stand pat’ and hold the line on interest rates – in the face of renewed inflationary expectations – as evidenced in the higher prices of gold, oil, wheat, and other commodities, as well as the low value of the U.S. dollar. But with the markets already having factored in a rate cut, the “stand pat” option was really no option at all. The reason: The moment the Fed said it was holding the line on short-term rates, the stock market would literally fall out of bed.

That meant that the central bank’s choice was a Hobson’s choice – for it was really no choice at all.

So the Fed opted to “protect” economic growth – and, in the process, mitigate the downturn in housing and the problems facing such highly leveraged players as financial institutions or hedge funds by dropping interest rates. It caught the entire market by surprise. This was much more than the market and I expected, and generated a rush out of cash and bonds. Why?

Very simple: A fear of re-acceleration in inflation. With a weak U.S. dollar and very strong global growth, the cuts add more fuel to the fire. And this will have a very beneficial effect on U.S. growth six to nine months down the line. While core inflation has recently been in a downward trend, the rise in the U.S. dollar-denominated commodities (oil, gold, other minerals and agricultural commodities) – together with the low value of the U.S. dollar – poses a major inflationary risk.

So, what’s your best defense in this situation?

Go on the offense by taking advantage of the expected continued increase in commodities prices by purchasing commodities producers, such as major global mining companies.

Buy into the more-promising emerging markets – such as Brazil – since they will be big exporters of these commodities. Also, many of these markets will benefit from major consumer booms as the economies evolve and develop.

The Fed acted boldly, and the markets responded likewise. We remain opportunistically bullish, with a preference for international and U.S. companies that will benefit from international growth.

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